Difference Between Exchange Rate and Interest Rate

Exchange Rate vs Interest Rate

Exchange rates and interest rates are both equally important in determining a country’s economic growth, inflation, levels of foreign trade, and other economic determinants. Exchange rates and interest rates are closely related, yet in no way they represent the same thing. These two very different concepts will be clearly explained in the following article along with an explanation of the relationship between the two, and the significance of them to a country’s economic stability and financial health.

What is Exchange Rate?

The exchange rate between two currencies represents the value of one country’s currency in terms of another country’s currency. The exchange rate between two currencies can be obtained from many sites on the internet, and this will clearly show how much one’s local currency needs to be used to purchase another currency. For example, when an American travels to Japan he will have to purchase Japanese yen in order to purchase goods and services. Assume that he travels to Japan on the 28th September 2011. The exchange rate between the United States Dollar and Japanese Yen on that day is 1USD=76.5431JPY. In this case, the dollar is much stronger as one USD can buy 76.5431 JPY. In the event that the currency values change as 1USD=70.7897JPY, the USD has depreciated in value as now one USD can only buy 70.7897, as compared to the 76.5431 earlier. There are a number of factors that can affect interest rates, which include demand and supply for a particular currency, trade levels between two countries, monitory policy, and other economic conditions.

What is Interest Rate?

Interest rates represent the cost of borrowing funds within a country. The rates that act as a benchmark for interest rates are the long term Treasury bill rates that are set by the country’s treasury department. The levels of interest rates represent a country’s economic policies in terms of whether they need to reduce inflation thereby increase interest, or stimulate expansion and economic growth through reducing interest rates. A country interested in promoting economic growth will reduce interest rates to induce firms to borrow more, invest more, expand more, and create more jobs. A country interested in reducing inflation will increase interest rates so that individuals will save more and borrow less, resulting in reduction in the money supply in the economy. In determining interest rates, the treasury will also consider critical factors such as the risk free rate in the economy (Treasury bill rate since T bills are considered to be very safe), levels of risk expected to be borne in making the investment, and the expectations of inflation.

What is the difference between Exchange Rate and Interest Rate?

Interest rates and exchange rates are two of the most powerful concepts for a country’s economic health and growth. Interest rates represent the cost of borrowing funds in an economy, whereas exchange rates represent the cost of one currency in terms of another currency. Both these factors are influenced by a country’s monitory policy, imports and exports, demand and supply of a particular currency, economic policies and plans as well as political factors. There is a close relationship between interest rates and exchange rates. Taking an example, if an investor decides to purchase US Treasury securities, he will have to purchase USD in order to do so. When interest rates are rising, he will want to purchase T bills, and his demand for USD will increase, strengthening the USD in relation to the currency sold. If the interest rates fall, the investor will want to sell T bills, therefore, will sell US dollars; this will result in a drop in the value of the USD in relation to the currency bought instead.